Use Equity (Stock) to Motivate Your Key Employees

by Paul Honeycutt and Ronald Smith

Paul Honeycutt (left) and Ronald Smith

Business owners who set up employee incentive plans generally do so to motivate their employees to work harder and smarter. Owners considering exiting their business can use incentive plans to accomplish a number of additional purposes:

1. To motivate the employee to increase the value of the company

2. To retain the employee through the owner's exit

3. To reward the employee for performance

4. To begin transferring ownership

There are several types of equity-based incentive plans owners can use to achieve these purposes. First is the incentive stock option (ISO) plan. The owner grants shares to key employees who would have up to 10 years to exercise their option to purchase those shares. At the date of exercise, each employee would pay the original grant price and incur no tax consequences. When the employee subsequently sells that stock, the employee would pay capital gains tax on the growth in value over the grant price provided that he or she had met the holding period requirements which would be the later of: (1) two years from the grant; or (2) one year from the date of exercise of the option by the employee.

This can motivate key employees without draining company cash. This is also a good deal for employees since it is unlikely they will have enough cash to buy out the company.

Business owners should be aware that using an ISO plan has several drawbacks: (1) several Internal Revenue Code requirements limit what the plan can and cannot do; (2) the plan does nothing to handcuff employees to the company; (3) it provides no tax benefits for the company; and (4) if the company repurchases the stock, it would do so with after-tax dollars.

Another approach is a non-qualified stock option plan. Under this plan the company would grant employees an option to acquire a specific number of shares. Unlike the ISO, employees would be taxed (at ordinary income rates) on the difference between the fair market value of stock and the exercise price at the time of the exercise. The company would receive a corresponding deduction. The company can choose to mitigate the disadvantage to the employee by providing a cash bonus in the amount of that employee's tax obligation. Like the ISO, the employee is not handcuffed to the company and if the employee would leave, the stock may be redeemed by the company with after-tax dollars.

A third option is a stock bonus plan where an employee receives a predetermined amount of ownership. Owners can base a stock bonus on a set performance standard, or they can assign whatever bonus amounts they feel are appropriate. The stock can be unrestricted or subject to substantial risk of forfeiture (employees forfeit all or parts of the bonus if they leave the company). In exit planning, forfeiture provisions are designed to support the owner’s exit timeframe objectives. Employees would initially receive stock distributions (rather than receiving an option or buying stock over time), thus motivating them to stay with the company.

There is no income tax consequence to the employee or tax deduction allowed to the business, until, or as, the forfeitures lapse. As forfeitures lapse, ordinary income equal to the value of the unrestricted portion of the ownership interest is recognized by the employee and the company receives a corresponding deduction. Normally, the employee makes an “83(b) election” to recognize the income tax consequence at the time of the bonus or when a non-qualified stock option is exercised even though the stock may be subject to a full risk of forfeiture.

Section 83(b) states that an employee receiving restricted stock can elect (in writing and within 30 days of the transfer) to have the ordinary income element “close” as of the date of the election so that any further gain is taxed at capital gain rates. In effect, the employee’s ordinary income tax consequence, and the company’s corresponding deduction, is the difference between the fair market value of the stock and the price paid, if any, by the employee.

The risk to the employee is that if he or she incurs forfeiture after making the 83(b) election, he or she will receive no offsetting deduction. While this employee incurred a tax consequence when he or she made the election, once he or she forfeited the stock, that employee does not recapture the tax paid. The potential disadvantage to the company is the need to repurchase, with after-tax dollars, the bonused stock, at its then current value, should one of the key employees leave after the forfeiture has lapsed. A stock bonus plan for employees is a tool that is well suited to meet many owners’ exit objectives.